How Tax Reform May Impact Markets and Revenue Weighting

The prospect and subsequent passage of U.S. tax reform helped drive a market rally that began in late November and continued into 2018 as investors cheered the bill’s potential stimulative effect on the economy.

Will the optimistic case prevail, and how might it impact market leadership? We offer three potential scenarios for how the economy and markets could perform in the wake of the tax bill’s passage and, in each case, examine the potential benefits and considerations of a revenue-weighted investment approach.

Revenue Weighting Offers Exposure to Value and Growth Stocks

As the name implies, our revenue-weighted strategies weight securities by company revenues, as opposed to market capitalizations, the approach used by traditional indices. In doing so, the strategies systematically seek to deliver long-term results by rebalancing quarterly toward a top-line fundamental that anchors portfolios toward attractively valued companies. While they are value-oriented, however, the strategies do not ignore growth stocks because they own all of the securities that the traditional index would, but in different weights. Ultimately, by having exposure to both value and growth stocks, investors do not need to attempt to time changes in value or growth leadership, because weighting by revenues historically has resulted in attractive performance in both types of markets.

At the portfolio level, revenue weighting historically has delivered more consistent sector and industry exposure relative to a market-cap-weighted method. Within each industry, this approach targets companies with higher sales and, therefore, tends to exhibit higher market share. Companies with higher market share are generally better able to capture economies of scale and also benefit from a higher barrier to entry than their lower-revenue-producing competitors.

Performance Leading Up to Tax Reform

We observed a shift in market leadership in the last two months of 2017 as tax reform became a reality. The year-end run-up in equities reflected a mix of cyclical sectors and those that stand to benefit most from changes to the corporate tax code, including the telecom, financial, and consumer discretionary sectors. Conversely, Technology stocks sat out much of the tax-reform exuberance, as these firms stand to benefit the least from the tax bill. The reason: A territorial tax system will dampen the appeal of the accounting practices that have benefitted the earnings of many multi-national technology companies of late.

During this time, our revenue-weighted strategies outperformed significantly, helping to erase earlier underperformance. Contributions to returns were driven by overweights to out-of-favor firms in the consumer sectors and underweights to information technology sectors.

Three Possible Outcomes for 2018

Given this context, we believe that there are three distinct outlooks for 2018, with varying outcomes for revenue-weighted strategies relative to market-cap-weighted indices.

1. More of the Same for the Economy and Markets
The U.S. economy continues to grow at a modest rate as the passage of the tax bill does not produce higher sustained growth. The U.S. equity market would likely continue to be led by a narrow subset of true high-growth companies. Our revenue-weighted strategies may underperform market-cap-weighted strategies in the short term, but will likely perform better than other strategies that are tilted more toward value relative to growth. In other words, the revenue-weighted strategies will likely participate in market rallies, but continually reweight each quarter away from market momentum and toward company fundamentals.

2. Value Thrives as Economic Growth Improves

Passage of the tax bill leads to improved economic growth and sector leadership as value-oriented sectors start to win consistently for the first time in years. In short, the trend that began during the last week of November continues. A revenue-weighted strategy would likely be well positioned to outperform as the tax bill can serve as the catalyst for higher sustained economic output and helps sectors that have been out of favor, such as those that are consumer driven, perform well.

3. The Cycle Ends

A longer-term outlook could see investors continuing to bid up the highest market capitalization stocks with the best momentum while the economic cycle matures. Ultimately the cycle, like every one before it, ends and market multiples come down. The revenue-weighted strategy, which does not have as much exposure to the highest market capitalization names and typically trades at a lower valuation, will likely be well positioned to experience improved drawdowns when multiples contract.

In the cases of scenarios 2 and 3, investors will likely receive little forewarning, and shifts in market conditions and/or leadership may escalate quickly as flows have already been moving toward value. Importantly, this fundamental approach applies over the long-term regardless of the macroeconomic backdrop because our revenue-weighted strategies have delivered robust capital appreciation by grounding security weights by fundamentals as opposed to letting the market determine the weights of holdings. In the meantime, our revenue-weighted strategies have the potential to capture most of the upside of this market, as we do not need to rely on only value or growth to drive performance.

This material is provided for general and educational purposes only, is not intended to provide legal or tax advice, and is not for use to avoid penalties that may be imposed under U.S. federal tax laws. OppenheimerFunds is not undertaking to provide impartial investment advice or to provide advice in a fiduciary capacity. Contact your attorney or other advisor regarding your specific legal, investment or tax situation.

OFI Global Asset Management (“OFI Global”) consists of OppenheimerFunds, Inc. and certain of its advisory subsidiaries, including OFI Global Asset Management, Inc., OFI Global Institutional Inc., OFI SteelPath Inc., OFI Global Trust Company, SNW Asset Management, LLC and OFI Advisors, LLC. The firm offers a full range of investment solutions across equity, fixed income and alternative asset classes. The views herein represent the opinions of OFI Global and are subject to change based on subsequent developments. They are not intended as investment advice or to predict or depict the performance of any investment. The material contained herein is not intended to provide, and should not be relied on for, investment, accounting, legal or tax advice. Further, this material does not constitute a recommendation to buy, sell, or hold any security. No offer or solicitation for the sale of any security or financial instrument is made hereby.

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